Crying wolf the third time

Photo: Anisur Rahman

During each of the last two years, 2005 and 2006, the IMF raised the alarm of rising inflation. It advised the Bangladesh Bank (BB) to tighten monetary policy to ward off this menace. BB complied without much thought if what was being said was actually true. There were gaping holes in their arguments that BB not only missed, but also ignored even when pointed out.
But this year there was a remarkable change. Egged on by the so-called think tanks, businesspeople and media personalities, who were taking pot shots at the IMF, Bangladesh Bank bravely decided not to respond to the IMF's cry of inflation for the third time with a further tightening of the monetary policy. But was the third time "no" on the back of the first two "yes-es" the correct response? Probably not.
BB's situation seems to be similar to the villagers of an ancient fable. A young shepherd boy who grazed sheep at the edge of the village thought of sprucing up his boring life with a practical joke. He cried: "Wolf." The villages rushed to his help only to find that the naughty boy was joking. A few days later the boy cried wolf again. The villagers again rushed to his help and were disgusted that they were fooled. Several days later the villagers heard an anguished cry of "wolf" again, but this time they decided not to respond. Unfortunately this time the wolf did attack and kill the hapless boy and many sheep. The moral of the story is that if one lies frequently (or says incorrect things), he will not be trusted even when he speaks the truth.
If this were an economic fable I would deduce another moral: if you do not verify facts before you leap into action you are likely to incur losses. In this story the villages did not independently verify the presence of the wolf; they believed the naughty boy. Twice they responded positively when he falsely (incorrectly) cried wolf and suffered losses in terms of lost time and effort. The third time the villagers made a worse mistake by not responding to the genuine cry of wolf and suffered even greater losses.
Perhaps not many people sympathise with IMF because their previous calls for tight money were not fully justified. It was not correct to claim the mild inflation that the country was experiencing during 2004 was mainly demand driven. Actually the non-food price inflation (akin to core inflation) fell by a third between 2002-03 and 2004-05 and was much lower than the average inflation. On the other hand, food price inflation during the same period more than doubled and was much higher than the average inflation. Hence, the moderate increase in inflation at the time was due mostly to food price inflation.
It was not difficult to establish that domestic prices of major food items were strongly tied to their international prices as one should expect to be the case in a small open economy. Hence, the inflation was mostly of the imported variety that was sustained by an accommodating monetary policy. It was unnecessary to put on monetary brakes at this stage since the inflation was still modest and business confidence was high. However, BB did obligingly tighten the money market by jacking up the interest rate. The full impact of the contractionary policy did not become evident until after more than a year, both because of a very buoyant investment demand and the usual lag of monetary effects. The current slump in investment is due to a complex interplay of forces unleashed by BB's contractionary monetary policy, the abnormal political situation post-2006, and inappropriate market interventions that severely eroded business confidence.
The situation in the second half of 2007 is markedly different from that of early 2005. At least three changes that have occurred are of significance for monetary policy. First, the government seems to have swallowed hook, line and sinker a highly questionable theory that held syndication and hoarding as mainly responsible for the essential price inflation. The consequent drive against the business community in search of hoarders quickly turned the buoyant business mood into a pessimistic outlook, resulting in a slow-down of business activities.
Second, a large number of people lost their livelihood and employment because of an ill-conceived drive against vendors. The slow-down of economic activities has also reduced employment opportunities. As a result incomes of people at the lower end of the income spectrum have suffered a decline. Inflation will have a particularly harsh effect on them.
Third and most important, inflation has risen considerably and can be no longer said to be moderate. It has now breached the double digit mark for the first time in a long while and threatens to become embedded in the system due to inflationary expectations. In the current situation there is little to be gained from an easy monetary policy in terms of increased investment, but a great deal to lose in the longer term if the economy ends up with runaway inflation. The IMF's cry of inflation the third time had a good deal of merit and BB should have given it a more serious consideration. Indeed, navigating the economy through the stormy seas of uncertainty would require close collaboration between BB and the Ministry of Finance on economic policy. The costs of mistakes will be high and we already have had a glimpse of that.
The full import of monetary policy was not fully understood even in the West until recently. This changed with the publication of the monumental work of Milton Friedman with Anna Schwartz on the monetary history of the US. They demonstrated convincingly that inappropriate monetary policies of the Fed were the principal determinants of the severity and the duration of the Great Depression of the 1930s that shook the very foundations of the western economies. Since then a great deal of care and scrutiny have been accorded to monetary policy in the West. The central banks that are responsible for designing and implementing monetary policy have gained a high esteem to the extent that some have been made autonomous to make them virtually free of political interferences.
Monetary policy-making is still in a formative stage in Bangladesh. It is not clear if BB fully appreciates the import of the responsibility it bears on behalf of the nation. Its servile policy-making does not inspire confidence in its ability to steer the economy through difficult times. It is unlikely that its demand for more autonomy will find favour in many quarters since it may translate into more influence of the IMF over the monetary policy of the country.

The author is Professor of Economics and Chairman of Bureau of Economic Research, University of Dhaka.